Negligence penalties for nondeductible, unreimbursed partnership expenses on individual returns.

Clearly, taxpayers cannot deduct expenses paid on behalf of another on their individual returns. In Michael T. Hines, TC Suture. Op. 2004-55, the Tax Court expanded this principle to include a partner and his partnership. The court did not allow the taxpayer to deduct expenses on his Form 1040 he incurred and paid that were directly related to the business of the partnership of which he was a member. The taxpayer argued that his reportable income from the partnership should be reduced by unreimbursed partnership expenses. However, according to the Tax Court, unless an agreement between a partnership and a partner states otherwise, a partner cannot deduct expenses incurred on the partnership's behalf on his or her personal return.

Laws and Regs.

Sec. 162 provides for the deduction of ordinary and necessary expenses incurred by a trade or business. Under Regs. Sec. 1.162-1(b)(7) and Temp. Regs. Sec. 1.67-1T(a)(1), an employee can deduct unreimbursed employment-related expenses as an itemized deduction, to the extent they exceed 2% of the employee's adjusted gross income (AGI). According to Temp. Regs. Sec. 1.67-1T(a)(1)(i), such expenses include transportation, subscriptions to professional journals, continuing education, professional dues, entertainment, supplies, etc., as long as they meet Sec. 162's "ordinary and necessary" requirement.

For Sec. 162 purposes, an "ordinary" expense is one that is normal, customary or usual for a business. A "necessary" expense is one that is appropriate and helpful for the trade or business. Ordinary and necessary expenses also have to be reasonable, depending on the facts and circumstances. Thus, a taxpayer cannot deduct expenses paid on behalf of another, because they are not ordinary and necessary to the taxpayer.

Hines

On his 2000 individual return, the taxpayer reported $16,122 of partnership income on Schedule E, which was $33,415 less than the income shown on the partnership's Schedule K-1. Hines underreported his partnership income by netting his unreimbursed expenses against the partnership's flowthrough income.

The Service determined a $9,500 tax deficiency and a $1,897 accuracy-related penalty. The taxpayer conceded that he should have reported the full Schedule K-1 income on his Schedule E; however, he argued that he was entitled to a Sec. 162 deduction for the unreimbursed expenses attributable to the partnership income.

As discussed above, Sec. 162 does not allow a taxpayer to deduct expenses paid on another taxpayer's behalf; see Cropland Chemical Corp., 75 TC 288 (1980) and Wallendal, 31 TC 1249 (1959). In Cropland, the taxpayer had claimed expenses for compensation paid on a joint venture's behalf. The joint venture had an employment contract with Cropland's sole shareholder, who provided services to the joint venture solely for its benefit. The amounts Cropland paid to the sole shareholder were not considered Cropland's ordinary and necessary business expenses; thus, the IRS disallowed the deduction.

Walleudal held similarly. The taxpayer had deducted from his laundry partnership income, interest he paid on the unpaid balance of the purchase price of the partnership interest. Wallendal claimed this interest as a trade or business expense on his Form 1040; the Service held that these expenses were not deductible in computing his AGI.

Exceptions

Although taxpayers cannot directly deduct partnership expenses on individual returns as a reduction of business income, there are exceptions. For example, deductions were allowed when a partnership agreement or routine partnership practice required a partner to pay partnership expenses from his own funds; see Frederick S. Klein, 25TC 1045 (1956). In that case, the court found that the taxpayer "routinely" paid for certain expenses (principally, travel and entertainment expenses), deemed ordinary and necessary business expenses to the partnership, from his own funds. It accepted this routine as tantamount to an agreement and allowed the taxpayer to deduct these expenses from his business income on his individual return. An important element of the court's decision was an oral agreement between the taxpayer and his partner to divide partnership profits by first allocating 5% of the sales to the former and then splitting the residual income 25%/75%, respectively. This special allocation to Klein helped substantiate the requirement for the unreimbursed partnership expenses.

In Hines, the taxpayer could not prove he routinely paid partnership expenses personally. He argued that he and his partner orally agreed that he would not seek reimbursement from the partnership for his expenses, but offered no evidence to substantiate the agreement's existence or its requirement that he pay partnership expenses from his own funds. The partnership agreement specifically stated, "[t]he Partnership shall have a non-reimbursement policy when expenses are incurred outside the partnership." It did not include any provision requiring partners to pay partnership expenses from their own funds.

Tax Court's Decision

Thus, the Tax Court ruled that Hines was not entitled to deduct unreimbursed partnership expenses on his individual return. It also imposed a Sec. 6662(a) 20% accuracy-related penalty for negligence.

Conclusion

Partnership agreements need wording specifically requiring partners to pay certain expenses personally, without reimbursement from the partnership, before partners can deduct them on an individual return. In the case of Klein, an established routine practice of incurring unreimbursed expenses, in conjunction with an oral amendment to the partnership agreement, was enough to support a personal deduction. Such expenses must still qualify under Sec. 162 as ordinary and necessary and have to be well documented. If an amendment to a partnership agreement under Sec. 761(c) is needed, it has to be completed by the partnership return's filing date, excluding extensions.

FROM ELIZABETH E. KOZENKO, COHEN & COMPANY, LTD., CPAs, AKRON, OH